Municipal and non-municipal credits (such as loans, bonds, securities, or other obligations) traditionally include a number of ownership value characteristics. Further, each of these ownership value characteristics has associated therewith a potential risk and a potential benefit (hereinafter collectively referred to as “loss/gain potential”).
With regard to traditional fixed rate bonds (e.g. traditional municipal fixed rate bonds), the bondholder typically assumes all of the loss/gain potential of each ownership value characteristic associated with the bond (that is, the bondholder traditionally assumes all of the risks and benefits of bond ownership). In issuing such fixed rate debt, an issuer typically pays its fixed rate bondholders a higher interest rate (versus non-fixed rate debt) to accept all of the risks and benefits of ownership of the debt. In essence, the issuer purchases insurance against these risks from its fixed rate bondholders. The compensation to the fixed rate bondholders includes both a higher fixed rate as well as the rights to the potential benefits associated with ownership of the debt.
On the other hand, with regard to traditional variable rate demand bonds (“VRDBs”), the issuer typically retains all of the loss/gain potential of each ownership value characteristic associated with the bond (that is, the issuer retains all of the risks and benefits of bond ownership). The interest rate on such traditional VRDBs is periodically reset to maintain the value of the bonds equal to par, thereby causing the issuer to benefit from favorable market conditions and to bear the cost of unfavorable market conditions.
In any case, as seen in Table 1, a number of representative characteristics that generally affect the value of ownership of municipal debt (and the associated risks and benefits of ownership) include:
TABLE 1Representative Characteristics That Affect The Value ofOwnership of Municipal BondsCharacteristicRiskBenefitGeneral level of interestIncreasing ratesDecreasing ratesratesExemption from state taxDecrease in marginalTax increasetax rate or repeal ofexemptionCredit of issuerImprovement in creditCredit deteriorationCredit of credit enhancerImprovement in creditCredit deteriorationCredit liquidity providerImprovement in creditCredit deteriorationSupply and demand forIncrease in supply orDecrease in supplymunicipal bondsdecrease in demandor increase indemand
By issuing traditional fixed rate debt, an issuer may essentially fully hedge each of the above characteristics (i.e., the issuer fixes both the cost and the benefit derived from the bond issuance). In contrast, by issuing traditional variable rate demand debt, an issuer may essentially retains all of the loss/gain potential of each ownership value characteristic associated with the bond.